Principles of Accounting – Concepts and Conventions

In India, there are numerous rules which must be followed while walking or driving on the road as it allows the smooth flow of traffic. Likewise, there are accounting rules that an accountant should observe while recording business transactions or recording accounts. They may be known as accounting concepts. Thus, it can be said that: 

“The term accounting concepts refer to basic rules, assumptions, and principles which act as a primary  standard for recording business transactions and maintaining books of accounts”.

What are the Objectives of the Accounting Concept?

• The foremost aim of accounting is to sustain uniformity and regularity in the preparation of accounting  statements.
• Accounting concepts function as an underlying principle that enables accountants in the preparation and maintenance of business records.
• It focuses to understand the business rules and regulations  that are needed to be followed by all sorts of business unit, and thus simplifying the elaborate and comparable financial information.

What are the Different Accounting Concepts?

Following are the different accounting concepts that are broadly used all around the world and thus are known as universally accepted accounting rules. The various accounting concepts are:

Business Entity Concept

This concept considers that the organization and business owners are two independent units. Thus, the business transaction and personal transaction of its owner are different. For example, when the business owner invests his money in the business, it is noted as a liability of the business to the owner. Likewise, when the owner takes away from the business cash/goods for his/her personal use, it is not served as a business expense. Hence, the accounting transactions are recorded in the books of accounts from the organization’s point of view and not the person owning the business.

Example:

Suppose Mr. Birla commenced a business. He invested Rs 1, 00, 000. He bought goods for Rs 50,000, furniture for Rs. 40,000, and plant and machinery for Rs. 10,000 and Rs 2000 left in hand. These are the assets of the business and not of the business owner. According to the business unit concept, Rs.1,00,000 will be considered by a business as capital i.e. a liability of the business towards the owner of the business.

Now lets assume, he takes away Rs. 5000 cash or goods for the same price for his personal needs. This withdrawal of cash/goods by the owner from the business is his private expense and not the business expense. It is known as Drawings.

Thus, the business entity concept implies that the business and the business owner are two separate/distinct persons. Accordingly, any expenses incurred by the owner for himself or his family from business will be regarded as expenses and it will be defined as drawings.

Accrual Concept

The term accrual means something is due, specifically an amount of money that is still to be paid or received at the end of the accounting period. It states that revenue is earned at the time of sale through cash or not whereas expenditures are recognized when they become payable whether cash is paid or not. Thus, both the transactions are recorded in the accounting period in which they connect.

In the accounting system, the accrual concept states that the business revenue is earned at the time goods and services are traded ignoring the fact when cash is received for the same. For example, On March 5, 2021, the firm traded goods for Rs 55000, and the payment was not received until April 5, 2021, the amount was due and payable to the firm on the date goods and services were sold i.e. March 5, 2021. It must be included in the revenue for the year ending  March 31, 2021.

Likewise, expenses are accepted at the time services are provided, ignoring the fact that cash paid for these services are made. For example, if the firm received goods costing Rs.20000 on  March 9, 2021, but the payment is made on April 7, 2021, the accrual concept needs that expenses must be recorded for the year ending March 31, 2021, even though no payment has been made until this date though the service has been received and the person to whom the payment should have been made is represented as a creditor of business firm.

In short, the accrual concept implies that income is recognized when realized and expenses are recognized when they become due and payable irrespective of the cash receipt or cash payment.

Accounting Cost Concept

The accounting cost concept implies all the business assets should be written down in the book of accounts at the price assets are bought, including the cost of acquisition and installation. The assets are not noted at their market price. It states that the fixed assets like plant and machinery, building, furniture, etc are noted at their cost price. For example, a machine was bought by ABC Limited for Rs.10,00,000, for manufacturing bottles. An amount of Rs.2,000 was spent on transporting the machine to the factory site. Also, Rs.2000 was extra spent on its installation. Thus, the total amount at which the machine will be noted in the books of accounts would be the total of all these items i.e. Rs.10, 040, 00. This cost is also known as historical cost.

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Dual Aspect

The dual aspect is the basic principle of accounting. It offers the foundation for recording business transactions in the books of accounts. This concept considers that every transaction recorded in the books of accountants is set on dual concepts. This states that the transaction that is recorded influences two accounts on their respective opposite sides. Thus, the transaction should be recorded at dual places. It states that both features of the transaction should be recorded in the books of account. For example, goods bought in exchange for cash have two aspects like paying cash and receiving goods. So, both the aspects should be recorded in the books of accounts. The duality of the transaction is generally revealed in the terms of the following equation provided below:

Assets = Liabilities + Capital 

The dual concept states that every transaction has a same effect on assets and liabilities in such a way that the value of total assets is always same as the value of total liabilities.

Going Concepts

The Going concept in accounting implies that a business activities will be transferred by any firm for an unlimited time. This simply states that every business has continuity of life. Thus, it will not be concluded shortly. This is a major assumption of accounting as it offers a foundation for displaying the asset value in the balance sheet.

For example, the plant and machinery was bought by a company of Rs. 10 lakhs and its life span is 10 years. According to the Going concept, every year some amount of assets bought by the business will be considered as an expense and the balance amount will be recorded as an asset in the books of accounts. Hence, if an amount is incurred on an item that will be used in business for many years ahead, it will not be correct to charge the amount from the revenues of that specific year in which the item was bought. Only a part of the cost price is noted as an expense in the year of purchase and the remaining balance is noted as an asset in the balance sheet.

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Money Measurement Concept

The money measurement concept presumes that the business transactions are made in terms of money i.e. in the currency of a country. In India, such transactions are made in terms of the rupee. Thus, as per the money measurement concept, transactions that can be expressed in terms of money should be noted in books of accounts. For example, the sale of goods worth Rs. 10000, purchase of raw material Rs. 5000, rent paid Rs.2000 are expressed in terms of money, thus these transactions can be noted in the books of accounts.

Accounting Period Concepts

Accounting period concepts refers to all the transactions recorded in the books of account should be based on the belief that profit on these transactions is to be determined for a specific period. Thus this concept says that the balance sheet and profit and loss account of a business should be prepared at fixed intervals. This is needed for various purposes like calculation of profit and loss, tax calculation, ascertaining financial position, etc. Also, this concept states that business indefinite life is classified into two parts. These parts are referred as accounting periods. It can be one month, three months, six months, etc.  Commonly, one year is regarded as one accounting period which may be a calendar year or financial year.

The year that begins on January 1 and ends on January 31 is termed as calendar year whereas the year that begins on April 1 and ends on March 31 is termed as financial year.

Realization Concept

The term realization concept implies that revenue earned from any business transaction should be included in the accounting records only when it is realized.  The term realization means the creation of a legal right to get money. Thus, it should be noted that selling goods is regarded as realization whereas receiving order is not regarded as realization.

In other words, the revenue concept implies that revenue is realized when cash is received or the right to receive cash on the sale of goods or services or both have been generated.

Matching Concepts

The Matching concept states that revenue and expenses sustained to earn the revenue must belong to the same accounting period. Thus, once revenue is realized, the next step is to allocate the accurate accounting period. For example, if you pay a commission to a salesperson for the sale that you record in March. The commission should also be noted in the same month.

The matching concept states that all the revenue earned during an accounting year whether received or not during that year or all the expenses incurred whether paid or not during that year should be regarded while deciding the profit and loss of the business for that year. This helps the investors or shareholders to know the exact profit and loss of the business.

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What are Accounting Conventions?

Accounting conventions are specific limitations for the business transactions that are complicated and are not clear. Even though accounting conventions are not generally or legally binding, these generally accepted principles sustain stability in financial statements. While standardized financial reporting processes, the accounting conventions regards comparison, full disclosure of transaction, relevance,  and application in financial statements.

Four major kinds of accounting conventions are:

• Conservatism: It informs the accountants to err on the side of caution when giving the estimates for the assets and liabilities, which means that when there are two values of a transaction available, then the always lower one should be mentioned to.
• Consistency: A company is asked to apply the similar accounting principles across the different accounting cycles. Once this selects a method it is urged to stick with it in the future also, if not it finds a good reason to carry out it in another way. In the lack of these accounting conventions, the capacity of investors to compare and evaluate how the company functions becomes more challenging.
• Full Disclosure: Information that is regarded potentially important and significant is to be fully revealed, irrespective of whether it is harmful to the company.
• Materiality: Like the full disclosure, this convention also bound organizations to put down their cards on the table, which means they need to completely reveal all the material facts about the company. The objective behind this materiality convention is that any information that could determine the person’s decision by regarding the financial statement must be involved.